Is Default Risk Priced in Australian Equity? Exploring the Role of the Business Cycle
Posted: 5 Feb 2012
Date Written: August 25, 2011
Using an extensive Australian sample, we explore two related issues in the context of a default risk asset-pricing factor (DEF) over the business cycle: whether a DEF can explain the size premium in the three-factor Fama–French (FF) model; and whether a DEF has a separate role itself in a four-factor version of the FF model. While we find that the default factor does not explain the success of size, our evidence shows it has a complementary role to small minus big and high minus low. Notably, subgroups of test portfolios likely to seriously challenge any asset-pricing model show evidence that the four-factor model is not perfect. Finally, while we find that conditioning on the business cycle itself has little impact, when we condition on a leading indicator, it has a positive (negative) effect on the estimated default (market) risk premium.
Keywords: asset pricing, business cycle, default risk
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